Tail Risk

In a recent memo to Oaktree Capital clients, Chairman Howard Marks writes
about "the time I spent advising a sovereign wealth fund about how to organize
for the next thirty years. My presentation was built significantly around my
conviction that risk can't be quantified a priori. Another of their
advisors, a professor from a business school north of New York, insisted it
can. This is something I prefer not to debate, especially with people who're
sure they have the answer but haven't bet much money on it."

This is an excellent illustration of the investment mind today. It treasures
mathematical models that produce certainty. The finance professor is talking
through his hat, but he need not fear an academic challenge. This is what the
tenured teach and, alas, what students take to their jobs.

Businesses and investment funds are managed in the belief that risk - which
is in the future (there is no risk to what has already happened) - can be captured
down to the last dollar by a professor's model. A problem here, for those who
have not spent time within this world, is they do not believe it. They cannot
really accept that a highly acclaimed asset manager is confined - and generally,
content to be confined - within the parameters as described.

Since it is difficult, if not impossible, to convince a sensible person this
is really how institutional money decisions are made, the following question
may help: "Do they - the professors, the CFOs, the investment managers, the
Federal Reserve, for that matter, which is similarly attired - really believe they
can know the future with such impossible precision, or, do they conduct their
operations within such parameters because they want to believe they
are authorities of the future?" The latter possibility is more believable.

Since this is the accepted method of managing businesses and funds, the allocation
of resources and investments runs through the same pipe. When asset markets
are flooded with artificial dollars, as is the case today, allocations rise
(no one wants to be left out), fill the tank, spill in all directions, without
regard for academic and central banking assurances, until they mock the gods. "All
correlations go to one," wrote Marty Fridson, currently CIO at Lehmann, Livian,
Fridson Advisors LLC.

Fridson made that statement about Long-Term Capital Management's mistaken
models that engulfed world finance in 1998. Here we are, nearly 20 years later.
That lesson has been ignored. World finance is far more leveraged and vulnerable
than then. It is, to a degree, understandable why professors and central bankers
are immune to reality. As Howard Marks wrote, they "haven't bet much money
on it." That is not true for companies and investors.

The fact that the institutional world measures and applies risk incorrectly
leaves corporate managers and investors vulnerable. The real risk, which was
probably the first thought of the sensible person, is described by Howard Marks
as a "permanent loss from which there won't be a rebound."

Yes. Finally, a statement that makes sense.

Marks offers his explanation for why academics (and the CFOs and CIOs they
taught), are walking hand-in-hand to the graveyard: "Volatility is the academic's
choice for defining and measuring risk. I think this is the case largely because
volatility is quantifiable and thus usable in the calculations and models of
modern finance theory. In [Marks' book, The Most Important Thing] I
called it 'machinable.'" Our world loves machines to make decisions, or has
given up fighting them.

The past two decades' APA (Asset Price Administration) has instilled an assumption
in those who continue to run with the markets there is no such thing as a permanent
loss. The S&P 500 fell 54% from 2007 to 2009. Today, it's higher than ever,
and rising.

There are millions of Americans who have suffered permanent losses and will
never recover. They bought the dot.com bubble,
or a no-no-no mortgage, or had to sell their stocks in 2008 to make sure they
could pay their bills. To rub their noses in the dirt, their interest rates
have been confiscated on what savings may remain.

Sheehan serves as an advisor to investment firms and endowments. He is the
former Director of Asset Allocation Services at John Hancock Financial Services
where he set investment policy and asset allocation for institutional pension
plans. For more than a decade, Sheehan wrote the monthly "Market Outlook" and
quarterly "Market Review" for John Hancock clients.

Sheehan earned an MBA from Columbia Business School and a BS from the U.S.
Naval Academy. He is a Chartered Financial Analyst.